On the profitability of the EU’s telecom sector: why the CEPR’s ‘good news’ story is misleading
Telecoms infrastructure forms the backbone of and is an enabler of Europe’s productivity growth and competitiveness in the growing digital economy.
The present debate around the ability of the telecoms sector to invest is therefore a crucial and meaningful one, with the revision of the Horizontal Merger Guidelines a once-in-a-generation opportunity to rewrite the rulebook and boost European competitiveness, investment, and innovation.
The GSMA and Connect Europe take note of the recent CEPR blogpost on the EU telecom sector’s ability to remunerate its cost of capital published by a group of economists from the Chief Economist Team at the European Commission. As stated by the authors, the views cannot be regarded as an official position of DG Competition or of the European Commission and all errors and views are only attributable to the authors. We regret that the full details and underlying data behind the analysis have not been published.
Nevertheless, we welcome the continued constructive engagement with the European Commission and DG Competition on merger policy reform and are encouraged by the reception of the study commissioned by the GSMA and Connect Europe, published this month.
Average profitability masks a reality of sub-scale struggling operators
The authors of the CEPR blogpost note that operators show large differences in performance with some not covering their cost of capital. However, their analysis relies on a consolidated group-level account of 14 large EU operators, a majority of which have large, fixed telecoms businesses. We note that even this analysis shows a downward trend of average ROCE minus WACC.
Focusing on average profitability does not show whether individual operators in specific markets earn their cost of capital.
To take the UK as an example: prior to the Vodafone-Three merger, there were two operators earning a positive ROCE minus WACC, while the others were clearly sub-scale and not earning sufficient returns to justify making capital investments (see figure below). The CMA, endorsed by the regulator Ofcom, allowed that merger on the basis that creating three scale players from a pre-merger market structure of two scale players and two sub-scale players would kickstart the type of investment competition needed to accelerate a sluggish 5G rollout.
From an investor perspective, it does not make sense to exclude goodwill
In M&A, operators pay a premium over the book value of assets because additional real value is recognised. The synergies are particularly significant for telecoms, where the multiplicative effect of combining networks and spectrum increases the capacity and resulting value of the networks by more than the sum of their parts. Excluding goodwill excludes these factors, and it creates an inconsistency when compared with WACC, which includes the total capital invested -including goodwill- and therefore reflects the full economic risk borne by investors.
A high dividend ratio does not mean a healthy sector
The analysis notes that operators have, on average, a high dividend payout ratio. However, it does not support the implication the authors seek to derive, but in fact the exact opposite.
When investment projects generate returns commensurate with their risk, the cash flows they generate tend to be reinvested in investment opportunities with a similar profile. It is only when risk-adjusted returns are inadequate compared to investor expectations that companies resort to paying higher dividends. The high dividend ratio is indicative of investment opportunities in the business/industry that cannot generate required returns and reflects structural underinvestment issues.
It is a known phenomenon in capital markets that low growth, low return stocks are far more likely to pay dividends compared to high growth, high return stocks.
Conclusion:
The CEPR blogpost is based on calculations that bear insufficient relation to business reality. While the authors themselves acknowledge ‘substantial heterogeneity’ and that ‘some firms consistently achieve ROCE above WACC, while others remain below’, their headline conclusions risk obscuring these critical nuances and provide a misleading picture of the health of European telecoms.
The more pertinent aspect to the merger guidelines review that DG Competition is managing should be to understand what market structures optimise investment incentives. In this regard, the financial indicators are clear: subscale mobile operators are struggling to generate returns that would justify incremental infrastructure investments.
The average does not replace the fact that several operators are subscale and thus clearly destroying shareholder value with ROCE below WACC. This can hardly be called a vibrant, competitive marketplace.